Tax incentives for early stage investors
From 1 July 2016, if you invest in a qualifying early stage innovation company (ESIC), you may be eligible for tax incentives.
The tax incentives for early stage investors (sometimes referred to as ‘angel investors’) are contained in Division 360 of the Income Tax Assessment Act 1997.
The tax incentives provide eligible investors who purchase new shares in an ESIC with a:
- non-refundable carry forward tax offset equal to 20% of the amount paid for their qualifying investments. This is capped at a maximum tax offset amount of $200,000 for the investor and their affiliates combined in each income year
- modified capital gains tax (CGT) treatment, under which capital gains on qualifying shares that are continuously held for at least 12 months and less than ten years may be disregarded. Capital losses on shares held less than ten years must be disregarded.
The maximum tax offset cap of $200,000 doesn’t limit the shares that qualify for the modified CGT treatment.
Investors that don’t meet the ‘sophisticated investor’ test under the Corporations Act 2001 won’t be eligible for any tax incentives if their total investment in qualifying ESICs in an income year is more than $50,000.
Qualifying for the tax incentives
To qualify for the tax incentives, investors must have purchased new shares in a company that meets the requirements of an ESIC immediately after the shares are issued. The shares must be issued on or after 1 July 2016.
If, after the company has satisfied these requirements, it ceases to be an ESIC, this won’t affect the investor’s entitlement to the early stage investor tax incentives for the shares.
If the investor is a trust or partnership, special rules apply so that the entitlement to the tax offset flows through to the member of the trust or partnership (or the ultimate member if there is a chain of trusts or partnerships).
If the investor is a superannuation fund, the trustee of the fund and not the fund members, would be entitled to the tax incentives (tax offset and the modified CGT treatment).
The early stage investor tax incentives aren’t available to you if:
- you didn’t purchase the shares in the ESIC directly from the company as newly issued shares
- the shares are not equity interests in the ESIC
- you are a widely held company or a wholly-owned subsidiary of a widely held company. A widely held company is either a company that is listed on an approved stock exchange or a company with more than 50 shareholders (unless certain requirements are met)
- your total investment in one or more ESICs for the income year is more than $50,000 and you didn’t meet the sophisticated investor test in relation to at least one of those share offerings
- you or the ESIC are affiliates of each other at the time the shares are issued. An individual or company is an affiliate of another entity where, in relation to their business affairs, the individual or company acts or could reasonably be expected to act in accordance with that entity’s directions or wishes or in concert with the entity
- you hold more than 30% of the equity interests in the ESIC (including any entities connected with the ESIC) immediately after you are issued with the new shares. An entity is connected with the ESIC if the entity either controls, or is controlled by, the ESIC, or both entities are controlled by the same third entity
- you acquired the shares under an employee share scheme
The early stage investor tax incentives are available to both Australian resident and non-resident investors.
The sophisticated investor test
Under the Corporations Act 2001, ‘sophisticated investors’ who meet certain requirements don’t have to be provided with a disclosure document, such as a prospectus or product disclosure statement, when being offered shares in a company.
You may be a sophisticated investor if, for example:
- you hold a certificate issued by a qualified accountant that confirms you meet certain asset and income requirements and the certificate is provided no more than six months prior to the qualifying shares being offered to you. At the time of publication, this certificate is available only if you have gross income of at least $250,000 for each of the last two financial years or net assets of at least $2.5 million
- you have paid at least $500,000 for the qualifying shares (either as a single offer or including any amounts you previously have paid for shares of the same class that you hold in the same company)
- you are offered the qualifying shares through a financial services licensee who is satisfied that you have previous investment experience that allows you to assess the offer and you sign a written acknowledgment that the licensee hasn’t given you a disclosure document in relation to the offer
- you meet the requirements of being a ‘professional investor’ under the Corporations Act 2001 (such as a financial services licensee)
- you have or control gross assets of at least $10 million (including any assets held by an associate or a trust that you manage)
A sophisticated investor whose investments qualify for the early stage investor tax incentives is not restricted as to the amount that they can invest in an ESIC in an income year. However their early stage investor tax offset is capped at a maximum amount of $200,000 for each income year.
Limits for investors who don’t meet the sophisticated investor test
If you don’t meet the sophisticated investor test in relation to at least one offer of qualifying shares in an ESIC during the income year, there is a limit on the total amount that you can invest to access the tax incentives.
In such a case, your investments in one or more qualifying ESICs in an income year must not exceed $50,000 in total. If your total investments exceed $50,000, you won’t be eligible for either:
- the early stage investor tax offset for any of your investments in that income year
- the modified CGT treatment for any of your investments in that income year.
This applies to all of the shares that were issued to you in that income year, including to the amount of your investments that are below $50,000.
This limit is intended to ensure that the tax incentives don’t encourage retail investors to be over-exposed to the risk that is inherent in investing in qualifying ESICs.
Example 1 – Limits for investors who don’t meet the sophisticated investor test
Tim pays $50,000 for new shares in a qualifying ESIC on 1 October 2016. Tim is not a sophisticated investor for this share offer. This is the maximum amount that he can invest in ESICs in the 2016–17 income year to access the tax incentives (unless he is a sophisticated investor in relation to a later ESIC share offer).
If Tim pays another $10,000 for qualifying shares in an ESIC on 1 November 2016 and is not a sophisticated investor at this time, he won’t be entitled to receive any early stage investor tax incentives, including in relation to the shares that he purchased on 1 October 2016.
Calculating the early stage investor tax offset
The early stage investor tax offset is generally equal to 20% of the total amount you paid to acquire the qualifying shares. However, the maximum offset that an investor and their affiliates are entitled to in an income year is $200,000. This includes any offsets that are carried forward from prior year’s investments.
An individual or company is an affiliate of an investor if, in relation to their business affairs, the individual or company acts or could reasonably be expected to act in accordance with the investor’s directions or wishes or in concert with them.
The effect of the $200,000 annual cap is that, for qualifying investments of up to $1 million, a 20% non-refundable carry-forward tax offset is available. Qualifying investments by investors and their affiliates that exceed $1 million in an income year won’t increase the amount of tax offset available to them, although the modified CGT treatment will apply to all of the shares.
If you don’t meet the sophisticated investor test, the maximum early stage investor tax offset that you can claim is $10,000, as your total annual investment in all qualifying ESICs cannot exceed $50,000.
Tax offsets directly reduce the amount of tax you have to pay, with each dollar of tax offset reducing your tax payable by the same amount. As the early stage investor tax offset is a non-refundable tax offset, it can reduce your amount of tax payable to zero, but it cannot result in a tax refund on its own.
If you don’t use all of your early stage investor tax offset in one year, you can carry forward the remaining amount for use in future income years. However, the total amount of early stage investor tax offset that you, and your affiliates combined, can use or carry forward in an income year cannot exceed $200,000.
Example 1 – Calculating the early stage investor tax offset
Savannah, a sophisticated investor, pays $4 million for new shares in ESICs during the 2016–17 income year.
Although 20% of the total amount Savannah has paid for the ESIC shares is $800,000, her entitlement to the early stage investor tax offset is capped at $200,000 (provided the other eligibility requirements for the incentives are met).
Savannah has an income tax liability of $50,000 for the 2016–17 income year. She uses $50,000 of the early stage investor tax offset to reduce her tax payable to zero. Savannah can carry forward the remaining $150,000 in early stage investor tax offset to future income years.
The modified CGT treatment applies to all of the shares that she purchased.
Example 2 – Applying the $200,000 cap: affiliates
A Co purchases $2 million of qualifying shares in an ESIC in the 2016–17 income year. A Co and Savannah are affiliates in the 2016–17 income year.
As the $200,000 maximum cap applies to Savannah and her affiliates, the combined tax offset claimed by Savannah and A Co in the 2016–17 income year cannot exceed $200,000.